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D.Muthukrishnan (Muthu), Certified Financial Planner- Personal Financial Advisor

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Wisely Speaking- 5

Posted by Muthu on March 24, 2012

I get atleast few responses in the form of mails from you for every piece I write. That gives me a hope that some of you really read what I write:-) People who happen to read it through the blog also write to me. Some put it in the form of comment as well. I want to share a part of what someone wrote to me after reading the last piece. 

“A well worded article. It touched me because I have gone through the phases which you had described – especially the pain and endurance and acceptance part. I am a cancer survivor and not long ago I was on my death bed supposedly. Up to that moment I was fighting cancer and was fighting for my life, thinking that I would win over cancer with my drugs, doctors and positive thinking. But one day when my heart nearly gave up and I was lying on the bed connected to the machines with the doctors at my side waiting with the defibrillators to revive if my heart gave out completely, realisation dawned on me. The truth that death could take me any moment it wished to and nothing could stop it. That was a moment of acceptance.

Strangely that was the moment I made my peace with death. Immediately after that, an enormous amount of peace engulfed me and I was totally relaxed for the first time since my treatment started. And ironically, death did not choose to take me away that day. As I read somewhere, “Death taught me to live”. Today though I have overcome my malady, I know I am living on borrowed time but I am living my life with a sense of gratitude and appreciation.”

Today’s piece may be long (when it wasn’t?); all the more because I won’t be writing again till the end of April. I’ll tell you why somewhere in this piece; which should atleast offer you an incentive to read till the end.

I get questions all the time as to what would be impact on the markets – based on budget, fiscal deficit, crude prices, U.P. elections, Euro zone issue, U.S. situation, middle east crisis, Iran going nuclear…. the list is endless.

Usually I try to avoid answering these kinds of questions and if pressed very hard, tell something based on what I feel. These questions and my answer are of no use to you.

I participate in the conference calls of some good fund managers. At the end of call, questions from advisors invariably pertain where the markets are headed… in next few months, this year, what is the Sensex target for this calendar year or this fiscal etc.

In the calls I attended in December, I heard everyone of them saying that conditions are very bleak and they expect a further 20% correction in the first quarter of 2012 with Sensex hovering around 12000+ levels. Since there are only few more trading days left for this quarter, looks like we may end up in the range of 17000+, 40% more than what they predicted.

These fund managers are really good at their job- managing our money. The reality is that no one knows where the markets are headed next month, next few months or even this year. So you can now appreciate:-) the media which tries to forecast everyday where the markets are headed today, tomorrow, next week, this month before the F&O expiry etc.

The problem is that investors think that someone is no good as a fund manager or advisor if he cannot predict the near term market movements based on various events and give projection for markets. If this is the filter which is going to be used to evaluate the tribe, I can tell you that none of us can pass the same. If few of us on occasions come out with flying colours on such forecasts, it is mostly due to chance, like flipping a coin.

Understanding certain broad parameters and how things work can ensure that we get our approach right and don’t waste time on such gossips. Instead we may gossip about a film star’s affair, talking about in-laws, boss or colleague at work etc. which are more interesting than talking about stupid markets:-)

To put it simply for better understanding, this is how things work. In the long run, a stock price is based on its earnings; a company’s performance is usually dependant on the economy or economies in which it operates. So if there is economic growth, there is corporate growth; resulting in increase of earnings and price of stock as it is slave to its earnings.

In the short run, there may or may not be correlation between the price and earnings but over a period it converges. Even if the earnings are not cyclical, the price movements are always cyclical. An earning of Rs.10/- per share in a bear market can command a multiple of 5, resulting in the price at Rs.50/-. In a bull market, the same earning can command a multiple of Rs.15 resulting in 3 fold price rise.

The most important thing to understand is even for some reasons if markets do not provide a better multiple for a stock, its price may still increase due to increase in its earnings. If the earnings of the above company grows at 18% per annum, in 4 years the stock price may double even if there is no expansion in the multiple. There is another way of  looking at it. The earnings for Sensex a decade ago was Rs.200/-. This year’s earning is pegged to be at Rs.1200/-+. Assuming a trading multiple of 15, Sensex level of 3000, 10 years ago is same as the level of  18,000 today. The valuations remain the same but the earnings (of the companies in Sensex) growth has resulted in 6 times growth in Sensex.

So there is no point in debating about whether Sensex would be 40,000 or 60,000 in next 5 years. It’s driven by 2 factors- earnings and the multiple given by the markets at that point of time for the earnings.

If you believe that India would grow economically in the next decade or two, then there is a strong case of investing long term in Indian equities. If you believe otherwise, then you would be better off not investing.

If you look at our GDP growth; it was 3.5% in 1960’s, 4.1% in 1970’s, 4.4% in 1980’s, 5.7% in 1990’s, 7.2% in the last decade, optimistic projection of double digit growth this decade if we get the infrastructure story right or even otherwise a good growth rate of 8% or 9%.

Also if my understanding is correct, there has never been a single year of negative growth (recessionary year) inIndia. It has been in the growth cycle for decades. The rate of growth is sometimes strong and sometime weak; but structurally it is in a prolonged growth phase. Given our low base, this phase may continue atleast for next two decades.

The situation both internationally and domestically for the last 4 years is not very great. Despite that our cumulative growth of GDP during the last 4 years is around 30%. Very few can have this kind of growth with out doing anything for infrastructure:-)

Again, all the growth rates mentioned above are real rate of growth, after adjusting for inflation. When inflation is not adjusted, it is called nominal rate of growth. If you get a salary hike of 10% this year and the inflation is 8%, you don’t say your salary growth is only 2%. Income tax department too would not accept this logic:-) If a company earned a profit of Rs.100 last year and earns Rs.120/- this year; it is 20% growth – no adjusting for inflation. But when GDP data is published, it is always adjusted for inflation. This understanding is vital. So if we assume an average inflation rate of 8% every year in the last 4 years, our cumulative nominal GDP growth rate works out to be around 60%+; Not at all bad considering the environment we and the whole world have been in.

So if we anticipate a nominal GDP growth rate of 14% or 15% in future, the corporate earnings may do much better than the overall economic growth which includes lesser growth sectors like agriculture as well. Over long term, the return from equities would be in sync with corporate growth and more precisely its earnings and the multiples provided for the same.

So if some one says that the long term annualized return in Equity/Sensex for the last 3 decades is 17% or 18%, it never means that you get 18% every year. This is also vital for understanding. You would have got 50% in a year, 30% in one, -40% in another etc. Normally a market goes through a complete cycle in 10 years; which is why we always tell the holding period in equity should not be less than 10 years. In general, the bull markets are always longer than bear markets; also positive years are more than negative ones. There are some international studies which say a bull market’s average span is 5 years and that of bear market is 3 years.

Again the word average can be mis-leading. This means we can invest money for 5 years, take it out and invest again after 3 years:-) It isn’t that simple. Nothing prevents a 10 year bull market or a 6 year bear market:-) Also as I’ve repeatedly pointed out, growth happens only in spurts, not sequentially. So even in a bull market you’ve days of sharp rises and sharp falls.

Enough studies and research has been done in this regard and the general pointer is, if you miss the best 1% of days (roughly 20 days) in 10 years, your return may probably equal a savings bank account return and if you miss 2% of days, you may not get any return at all or may even loose some capital.

So do not time the markets and make investing a regular habit. You may time only in the following situations- making lump sum investments when valuations are attractive, not making lump sum investments when valuations are expensive, start planning to phase out withdrawal a year or two before you near your goal – retirement, child’s higher education, daughter’s marriage etc. Again the term attractive or expensive valuation is relative. In a bear market, when you invest at attractive valuations, the markets can go further lower too and become more attractive:-) That’s fine as our investment outlook is long term and notional loss should not bother us. Likewise it is very difficult to know what is an expensive valuation in bull markets. Bull markets are very euphoric and we may think valuations are high, still it may run higher for even few years. Only in hindsight we’ll know when the valuations get peaked out; that’s also fine. It is better to be safer than sorry. In bull markets, especially at later stages, it is better to continue only monthly regular investments and not make any lump sum investments.

Strangely you would see all kinds of people who say something is expensive at a multiple of 15 would not mind investing at even 60 or 70 multiples in a bull market. Fear will be at peak in bear markets and greed would be at its peak in bull markets.

In bull markets, you would see pundits saying why this time bull markets would never end and go on for ever as we are into some new era. The same pundits would ask you to avoid equities all together in bear markets. Both bull and bear markets never goes on forever and there is no new era as far as financial markets are concerned. The details or context of cycle may vary, but cycles never change.

Reading financial history is always helpful. In 1970’s, the petrol price almost increased by 15 times to touch $40 a barrel. Then it went all the way down to $12 in 1980’s, reached the $40 mark again during first gulf war… In the recent years, it went as high as $150 in 2008 and came down to $40 levels in 2008-09. All the above numbers have not been adjusted for inflation and were then prevailing prices.

When gold ran up in 1970’s and went above $700 per ounce, the prediction was gold has reached a permanent high plateau and pundits thought it may even touch $2500. Well it went all the way down to $300 per ounce in 1990’s. Infact for someone who invested in gold at the peak of 70’s boom, it would have taken 28 years to just recover the capital. Even after more than 3 decades of $2500 per ounce predictions, gold is still at around $1700 per ounce.

The problem in commodities is that cycles are very longer. The average bull cycle is 10 years and average bear cycle is 20 years. Unlike equities, you would have noticed not only cycles are longer but negative period is much more than the positive period for commodities. When you trade or invest in commodities (gold is also a commodity), please keep this in mind. Of course, I would never advice trading or investment in any commodities. For social reasons, we do need gold and silver and a small portion of one’s asset can be invested in gold more for the purpose of diversification than anything else.

So completely ignore the news flow. Now we’ve started worrying not only aboutIndia but the entire world. Every day somewhere something is happening. Change in interest rates, consumer confidence, industrial data, unemployment data, consumption data, market data, inflation data etc…We hear it all over from China, U.S, Germany, France, U.K, Japan, and our own India and keep wondering what to do with all this information. The best thing is just ignore. World has never been a perfect place and it never would be. In bull markets, bad news is ignored and good news is magnified. In bear markets, bad news is amplified and good news is completely ignored. Cycles continue to happen and there would never be a perfect domestic or international situation.

Given that our markets have been at the same level for almost 5 years, the probability of a strong bull market is more. I do not know whether it would start this year, or next or 2014… Since our economy is in a prolonged growth phase and our market is still away even from the highs it achieved more than 4 years ago, I would assign a higher probability for a strong bull market in the years to come.

Though I’ve highlighted it many times, please remember the 17% or 18% long term returns from the equities is inclusive of all the bear markets as well.

In markets, knowledge or degrees doesn’t matter much. I’m not saying that you should be stupid or dumb. But if knowledge or degree matters a lot, all Ivy League and top B schools graduate should be the best investors. Often all these people including media pundits are dependant on their employment income for their survival and not their asset based income.

In that sense, you and I also have an equal opportunity in the market if we get our approach correct. Prof.Sanjay Bakshi who is a rare combination of being strong both in academics and investing has made a mention about an investor in Chennai, who has not gone to college, living in a middle class apartment, driving a Honda City, having a net worth of Rs.50 crores through right approach towards investment.

I don’t know whether you ever heard of Hetty Green, the first richest woman in the world in late 1800’s. EvenNew York Citywas dependant on loans from her for its survival few times. You may definitely not want to live the life the way she lived but still understand the power of compounding, conservative and value based approach.

Coming to the point of why I would not write till end of April; I would be sending you the portfolio summary for the financial year 2011-12 with my comments or notes, wherever required. In my opinion, a yearly review for you as an investor is frequent enough. Constantly looking at prices regularly would do you more harm than good. What is the point in looking at prices everyday or week or month after deciding your holding period is going to be 10 or 15 years? There is no need to get elated or weep at notional gains or loss.

Normally any asset class tends to deliver its long term return- whether equity or even debt based products like MIP only if you stay for the required holding period. There was all round panic when MIPs failed to deliver in first half of 2011, whereas in the last 6 months it has given good returns. When we say a holding period for a MIP should be 5 years, we say that with a reason. In any economy, especially high growth economies, interest cycles happen continuously. Though we cannot predict the cycles in advance, our understanding based on our experience and data pointers is, the returns get evened out if the holding period is 5 years.

We take every care to ensure that the data we send you is correct. Since the reports are generated out of data feeds we receive from RTAs (like CAMS, Karvy), if you find any discrepancy in the report, please do write to us. Also if you do not receive the report latest by April 30th, please write to me. I might have accidentally missed out and would send the report based on your intimation.

We may meet again in May:-)

2 Responses to “Wisely Speaking- 5”

  1. amol said

    Dear Muthu,

    This article is masterpiece and I am going to maintain a copy of it with me.
    I have some question. I have read on many blogs and everyone is quite confidant about india’s growth story for next 2 decades as you also mentioned on your blog couple of times. If this is the case what is the probability that sensex can give above 15% CAGR returns by end of 2032.
    I know this question has no real meaning but when we say that india is in growth story can we make such expectation of 15% CAGR over 20 years

    thanks for this wonderful article.
    will miss your article throughout April. Please write more often


  2. Amar Shah said

    Reblogged this on Financial Markets.

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